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David Louton

David Louton

David Louton is a Professor of Finance at Bryant University where he has taught investment related courses for the past 25 years. His recent research…

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Is Oil Pushing Down The Economy, Or The Other Way Around?

Is Oil Pushing Down The Economy, Or The Other Way Around?

Conventional wisdom has long held that when oil prices drop, consumers experience an increase in discretionary income while corporations experience a boost in profit margins. At the same time, companies in the consumer discretionary sector get a boost in sales volume as consumers spend more on discretionary items.

The logical conclusion of this scenario would be record gains in the stock market as investors anticipate strong corporate profits. However, those expectations were largely shaped by past supply shocks – mostly on the negative side – and recent stock market performance suggests that we are now dealing with an entirely different dynamic.

This time we have both a supply glut and a drop off in demand. As a result, oil prices have been driven to levels that are simply not viable for the OPEC countries. A drop in oil prices should be good for both markets and the real economy, but that is not turning out to be true this time. What does this mean for investors? Is it an opportunity to buy equities at depressed prices, or a time to move to safer asset classes? Related: Venezuela Raises Fuel Prices By More Than 6,000 Percent

Is oil the tail or the dog?

With the reversal of the usual relationship between oil and equity prices, one might be tempted to ask “which is the tail and which is the dog”? It is true that over the last year oil has suffered near simultaneous supply and demand shocks. These resulted from the slowdown of the Chinese economic juggernaut, on the one hand, and the breakdown of price discipline within OPEC on the other.

OPEC’s problems have been exacerbated by the fact that their global market share has diminished as oil production has increased in the U.S., Canada and some other non-OPEC countries. Although this transition has taken place gradually and has been unfolding for some time, it has had much the same effect as a secondary supply shock and has also done much to undermine OPEC’s anchor tenant position in global oil production.

As oil prices have dropped, it has become increasingly difficult for OPEC countries to maintain the entitlement commitments that are critical to their social and economic stability. According to data compiled by the International Monetary Fund, the fiscal break-even oil prices for OPEC member countries range from $50 to $137. Of course these numbers assume a functioning OPEC quota system, so their validity may be questionable.

Nevertheless, they illustrate that all OPEC countries are hurting at this point, though to differing degrees, which explains why they have had such difficulty reaching a lasting and mutually beneficial accord regarding production levels. Instead, they have opened the flood gates in an effort to make up budget shortfalls through higher volume. This is an extremely counterintuitive move given the weakening of demand and the fact that oil is a non-renewable resource that will almost certainly sell at a far higher price later.

The fact that OPEC has gone down this path at all, demonstrates how unpalatable and potentially destabilizing significant fiscal cutbacks are likely to be in individual member countries. Aside from fiscal cutbacks, the only remaining alternative is for countries that have sovereign wealth funds to begin liquidating assets to make up the shortfall.

This has already been happening. During the last few months alone, draw downs in funds owned by Persian Gulf countries have accounted for an estimated $300 billion sell-off, with additional selling attributable to oil producing countries in other regions. The net impact of this dumping of assets in an already weak market has been to further depress stock prices, fueling concerns about the possibility of global recession and potentially doing further damage to aggregate demand. In the end, it turns out that oil is neither the tail nor the dog, it is both. Related: The Decline Of The Coal Industry Is “Long-Term” And “Irreversible”

Will government use its power for good?

The Federal Reserve’s decision to initiate a gradual rise in interest rates starting late last year, was welcomed as a sign that the economy was at last strong enough to move out from under the shadow of the 2008-2009 crisis and into a less interventionist future. Given the slide in the stock market, that scenario is most likely off the table for the time being, however, one unavoidable consequence of the Fed’s policy choice has been a strengthening of the dollar.

This has exacerbated the drop in oil prices and has contributed to a negative wealth effect in the most commodity sensitive parts of the global economy, with a resulting negative impact on aggregate demand. While the Fed has indicated a willingness to hold off on further increases in the interest rate and there has even been some talk about the possibility of negative interest rates, as we have already seen in Europe and Japan, it seems increasingly clear that the Fed is in a corner with very little room to maneuver.

It is time to face the fact that continuing to lean so heavily on monetary policy alone may not be consistent with the goal of long-run domestic and global economic health. Fiscal policy alternatives should move to center stage at this point, but the chances of that happening in an election year are slight. Related: Solar Power Growth Soars In Africa

What does this mean for investors?

Current pressures on the OPEC nations suggest that for the foreseeable future oil prices will be driven by weakness in global demand rather than supply constraints. However, unless the cycle of feedback effects that have driven oil and stock prices downward at the same time, can be broken through carefully orchestrated policy initiatives, it is unlikely that near term demand will recover sufficiently to support anything more than an anemic rebound.

For the time being, investors should avoid taking their cues from the stock and commodity markets and should focus instead on evidence of demand in the real economy. Any emerging political consensus regarding fiscal policy alternatives would be a positive sign for both markets, as would signs of resilient consumer demand in the domestic economy.

By Dave Louton for Oilprice.com

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